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Natural gas rigs continued to fall last week from 389 to 375 continuing a three week drop in rig counts. The number of natural gas rigs drilling has fallen by 15% over the past three weeks.

The continued drop in natural gas rigs was somewhat surprising given a seven week rally in prices from $3.15/MMBtu in mid-February to ~$4.10/MMBtu currently.

From a longer term perspective, natural gas rigs have generally been declining or flat since 3Q11.

A focus on the most productive wells, an increase in efficiency, and gas produced as a result of oil-targeted drilling are all factors that have contributed to a flush in natural gas supply, despite a cutback in rigs.

Baker Hughes, an oilfield services company, reported that rigs targeting natural gas decreased from 389 to 375 for the week ending April 5th. This week’s drop followed two consecutive weeks of natural gas rig count declines, and over the past three weeks the number of nat gas rigs drilling has fallen by 15%. These continued declines are somewhat surprising as natural gas has recently had a strong rally due to colder than normal weather. As recently as mid-February, natural gas was trading at $3.15/MMBtu, however, natural gas closed at $4.13/MMBtu on April 5th.

From a longer term perspective, natural gas rigs have been largely falling or flat since October 2011 in response to sustained low natural gas prices (see natural gas price graph below).

To provide some context, the number of rigs drilling for natural gas can be indicative of how companies feel about the economics of drilling for natural gas. More natural gas rigs drilling generally means companies feel bullish on the natural gas environment. Additionally, rigs drilling can also be indicative of future supply as more rigs drilling implies more production. Therefore, market participants monitor rig counts to get a sense of oil and gas producers’ sentiment, and as a rough indicator of future expected supply. This week’s decrease in rigs may be a signal that producers are feeling negative about the current price environment.

As mentioned, rig counts have largely been in decline since late 2011. With this decline in rigs throughout most of 2012, one would expect a drastic cutback in natural gas production, and, therefore, a bump in prices and natural gas producer valuations. Despite this, supply has remained flattish thus far, with prices rebounding somewhat since 2Q12 lows, but mostly from demand drivers rather than supply cutbacks. The below chart shows natural gas production in the U.S. over the past twelve months; one can see that supply has not fallen off significantly.

There are a few major likely reasons why natural gas production has not yet followed the drop off in rig counts.

The rigs targeting gas right now are likely targeting the most productive and economic wells, and the rigs that were put out of work were targeting more marginal wells. This has resulted in a large cut in rigs, without a proportionate cut in supply.

Rigs that are classified as targeting oil are not included in the natural gas rig count, and oil wells produce both oil and natural gas (often called “associated gas” when it comes from an oil well). Oil prices have remained relatively robust, and the pace of oil drilling has remained frenzied, with the by-product being associated natural gas production.

Producers have become more efficient, producing more gas with less rigs due to advancing technology and deeper knowledge about the areas in which they are drilling.

That is not to say that supply cuts will not be experienced at all. Note that in the above graph, U.S. natural gas production goes only through January 2013, as that is the last period that the DOE has reported thus far. One has yet to see what the DOE will report for February and March. Additionally, companies plan their expenditures year by year, and it is likely that given the continued low price of natural gas and continued support in the price of oil, that companies will further shift capital away from natural gas and towards oil in their 2013 drilling budgets.

However, thus far the rig reductions have not put a significant dent in natural gas supply. Therefore, natural gas prices have remained relatively low which has muted the margins and valuation of domestic natural gas weighted producers, such as Chesapeake Energy (CHK), Comstock Resources (CRK), Southwestern Energy (SWN), and EXCO Resources (XCO). Additionally, natural gas prices affect the US Natural Gas Fund (UNG), an ETF designed to track Henry Hub natural gas prices, the major domestic benchmark for the commodity. This past week saw a decrease in rig counts, which can be construed two ways: (1) that producers are feeling less positive about natural gas drilling given the rise in prices and (2) that a decrease in rigs could decrease natural gas supply which would create positive price pressure.